Question

Lease versus Buy Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply: The machinery falls into the MACRS 3-year class. Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance. The firm's tax rate is 40%. The loan would have an interest rate of 15%. It would be nonamortizing, with only interest paid at the end of each year for four years and the principal repaid at Year 4. The lease terms call for $400,000 payments at the end of each of the next 4 years. Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of $200,000 at the end of the 4th year. MACRS Year Allowance Factor 1 0.3333 2 0.4445 3 0.1481 4 0.0741 What is the NAL of the lease? Round your answer to the nearest dollar.

Answer 1

I. Cost of Owning:

	0	1	2	3	4
After-tax loan paymentsa		($135,000)	($135,000)	($135,000)	($1,635,000)
Depr. tax savingsb		$199,980	$266,700	$88,860	$44,460
Residual value					$200,000
Tax on residual					($80,000)
Net cash flow	$0	$4,980	$131,700	($46,140)	($1,470,540)

                       PV of owning at 9% = −$961,978.09

               II.   Cost of Leasing:

	0	1	2	3	4
Lease payment (AT)		(240,000)	(240,000)	(240,000)	(240,000)
Net cash flow	$0	(240,000)	(240,000)	(240,000)	(240,000)

PV of leasing at 9% = −$777,532.77

III. Cost Comparison

                  Net advantage to leasing (NAL)= PV of leasing - PV of owning

                                                                     = −$777,532.77 – (−$961,978.09)

                                                                     = $184,445.32

                  ^aAfter-tax interest payments = (0.15)($1,500,000)(1-0.40) = $135,000.

                  ^bDepreciation tax savings, base on MACRS 3-year life and $1,500,000 cost of new machinery:.

                                            MACRS                           Deprec. Tax Savings

                  Year            Allowance Factor          Depreciation                   T (Depreciation)

                     1                   0.3333                          $499,950                              $199,980

                     2                   0.4445                            666,750                                266,700

                     3                   0.1481                            222,150                                  88,860

                     4                   0.0741                            111,150                                  44,460

Since the cost of leasing the machinery is less than the cost of owning it, Big Sky Mining should lease the equipment.